Money-market mutual funds have been one of the most popular products for investors but recent changes have made the product less so. A couple years ago (HERE), we wrote about the tactical opportunity that banks had for capturing inexpensive deposits from institutional and corporate investors. The tactic worked beautifully as banks that focused on pitching their money market deposits and CDs saw an influx of funding back in late 2014 and 2015. While the new money is slowing into the banking industry from the mutual fund complexes, the impact of regulatory changes isn’t complete. Now, as of last week, these changes have now taken effect and the last groups of investors are reconsidering bank certificates of deposits and money market accounts as a place to park money. While there is still opportunity for banks to garner core funding due to these changes, there are other, longer-term aspects to these changes that banks should be aware of. In this article, we highlight some of those changes and discuss some mitigating tactics that banks can employ to insulate themselves.
Money-market funds started in 1971 as an alternative to bank deposits, and these funds peaked at $3.9 trillion in January 2009. Historically, money-market mutual funds were allowed to keep share prices fixed at $1, also known as constant NAV (or net asset value). The constant NAV was seen as crucial for investors because it made the funds seem more like bank deposits. Unfortunately, investors buying into money-market mutual funds are buying a share of a pool of obligations and the value of those obligations can go up or down. Starting October 14, 2016, certain money-market mutual funds will cease pegging investments at the fixed $1 value. This sweeping change will permanently affect the way investors allocate their capital, the cost of funding for national banks and the cost of funding for community banks.
Change In Regulations
Money-market funds are divided into prime funds and government funds. Prime funds buy certificates of deposit from banks, short-term obligations from municipalities and corporate IOUs. Government funds purchase T-bills and other short-term US debt which typically mature in 270 days or less. For 40 years money-market funds offered better returns than bank deposits and appeared to be just as accessible and just as safe. In September 2008, the Reserve Primary Fund, the oldest U.S. money-market fund, and one which invested in debt issued by Lehman Brothers Holdings Inc., collapsed, and caused a run on other funds. Investors lost hundreds of millions and a federal bailout that put taxpayers on the hook for trillions of dollars saved the funds, and the broader credit markets. Post the financial crisis, regulators were determined to take steps to reduce the funds' systemic risk. In 2014, the U.S. Securities and Exchange Commission passed rules aimed at protecting investors and making the financial system more resilient.
The $1 fixed price, will give way to floating values after Oct. 14th for prime funds. In addition, prime funds will be allowed to impose liquidity fees and limit investor withdrawals in times of crisis. The government funds are exempt from these changes. Investors have been shifting hundreds of billions of dollars out of prime funds and into government funds. The graph below shows how investors have favored government funds at the expense of prime funds
Impact on National Banks
The largest US banks have historically been large issuers of CDs bought by prime funds. The regulatory reform has triggered an exodus from prime funds and has also increased the yields prime funds need to offer to attract investors. Hundreds of billions of dollars of funding for lenders such as JPMorgan and Wells Fargo Bank has moved from commercial paper and CDs to on-balance sheet deposits. The national banks have been forced to pay higher costs to issue obligations in prime funds and they have also been forced to find alternative sources of funding (also at higher costs).
The regulatory change means that the biggest U.S. banks will pay more to borrow while the government will benefit from lower short-term financing costs. The graph below shows the differential between yields on 90-day government and non-government obligations. That spread rose in late September to almost 70 basis points, the widest since May 2009.
Impact on Community Banks
How will these regulatory changes affect the cost of funding at community banks? The graph above shows the percentage of deposits that are controlled by all banks in the country. The steepness of the curve demonstrates that the largest banks control most of the deposits. The top 50 banks in asset size control more than 75% of all deposits and the top 10 banks in asset size control 54% of all deposits. While the regulatory changes will have a direct effect on the largest banks that have historically relied on money-market funds as a major source of funding, the deposit market is fungible and the cost of the limited amount of retail and commercial deposit supply will increase. The current increase in deposit rates and the increased sensitivity of these deposits to interest rates will permeate the entire banking industry.
On the heels of this regulatory change, community banks should be aware that as interest rates rise, average cost-of-funding will more closely follow LIBOR and the retail and commercial deposit rates will be higher relative to LIBOR compared with historical behavior. The impact for community banks is that balance sheets will be more liability sensitive and the deposit betas will be higher.
While the recent regulatory changes affecting money-market prime funds was meant to stabilize the financial system and protect investors, the changes will also increase cost of funding for all banks, not just the money-centered banks. Community banks need to be aware of this impact and manage their ALCO process accordingly. Cost of funding, especially in a rising rate environment, will create higher relative costs and higher betas for all deposits.
Submitted by Chris Nichols on October 18, 2016